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The contribution of dairy and food products to the product mix now account for half of Nestle’s revenues.

Aarati Krishnan

The Nestle India stock is a good investment option for those who would like to own a defensive stock in volatile markets. Nestle’s high profitability and return ratios and the healthy cash flows make it a likely beneficiary from any flight-to-safety in an uncertain market.

At the current market price of Rs 1,470, the stock trades at about 22 times likely earnings for CY2009. That isn’t cheap and represents a big valuation premium over the broader market.

But Nestle India now trades at a discount to FMCG behemoth, Hindustan Unilever, whose PE stands at 27 times (2009E) after the stock’s recent rally.

Nestle India’s presence in under-penetrated FMCGs such as culinary and dairy products endow it with strong growth potential that is not vulnerable to the slowdown. Though its profit growth has been muted in recent quarters, a perceptible softening in input prices is set to expand Nestle’s profit margins from here on.

Nestle India has traditionally derived its revenues in equal parts from five major business segments — dairy products, prepared dishes and cooking aids, beverages, chocolates and infant foods. However, the company has stepped up the pace of launch and promotional activity in the dairy and foods businesses in recent times, even as regulatory restrictions on advertising in the infant foods business and slower growth in chocolates limit their potential.

As a result of this, the contribution of dairy and food products to the product mix has improved significantly and now account for half of Nestle India’s revenues. The company has in recent months unveiled plans to expand its distribution reach and product penetration in C&D towns. There is a conscious focus on “nutrition” to exploit the consumer preference for health and wellness products.

In keeping with these plans, Nestle India has also been expanding the premium end of its dairy portfolio with value-added products such as Natural and Probiotic Dahi, Yoghurt and Slim and Pro-Heart Milk.

These may not add substantially to revenues in the near term as they cater to niche markets, but may be margin-accretive as they command premium pricing.

In culinary products, apart from extending the Maggi franchise through the launch of Cuppa Mania pre-cooked noodles, Maggi has also been extended into ready-to-cook products such as gravies.

Products such as these may attain critical mass as a larger proportion of FMCG sales happen through modern format stores and large retail chains. Unlike larger FMCG segments such as soaps or personal care products, Nestle’s businesses are marked by low competitive threat. Gujarat Cooperative Milk Marketing Federation (Amul) and Britannia are the only competitors in the dairy business and Hindustan Unilever and ITC in the foods business; even these companies don’t operate in exactly the same product segments as Nestle.

Over the past four quarters, Nestle India has steadily maintained its topline growth at 22 per cent-plus levels, superior to most industry peers. In contrast to players such as Hindustan Unilever, this growth is driven more by underlying volume sales rather than price increases, though Nestle too has taken its share of price increases in the past two quarters.

Escalation in prices of key inputs — milk, coffee and vegetable oils — has kept margins under pressure over the past few quarters and prevented healthy topline growth from trickling down to profit growth. Growth in operating profits has decelerated from 34 per cent in the March quarter to a shade over 10 per cent in the September quarter. But the situation may now be set to change with the sharp moderation in global milk and vegetable oil prices.

Global milk prices have halved from their July peak while vegetable oils too have corrected sharply. Global coffee prices have declined by close to 20 per cent from their early October peak. All this points to scope for significant margin expansion for Nestle over the coming quarters.

Items such as ‘impairment charges’ and ‘provision for contingencies’ have been a constant feature of Nestle India’s quarterly numbers over the past few years and tend to be wild cards in determining the profit performance. But the incidence of these charges has fallen significantly in 2008.

Nestle’s high tax incidence and rising dividend payouts infuse confidence in governance-related aspects. The company paid a dividend of Rs 30.5 per share in 2008, including a special dividend component of Rs 7.50 out of excess reserves accumulated in prior years.

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